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Investment Analysis and Portfolio Management

Major Asset Classes and MarketsRef Ch 2, BKMAttila OdabasiMain Points:Major Asset ClassesMoney market instrumentsCapital market instruments

#1Money Market InstrumentsCharacteristics: Liquid, marketable, low risk (safety)Examples: U.S. Treasury bills (T-bills), bank certificates of deposit (CDs), corporate and municipal money market instruments.

Potential gains/losses: A known future payment -except when the borrower defaults (i.e., does not pay).

Price quotations: Usually, the instruments are sold on a discount basis, and only the interest rates (yields) are quoted.

Therefore, investors must be able to do calculate prices from the quoted rates.#5Classifying SecuritiesBasic TypesMajor Subtypes Interest-bearing Money market instruments Fixed-income securities Equities Common stock Preferred stock Derivatives Futures Options#3Interest-Bearing AssetsMoney market instruments are short-term debt obligations of large corporations and governments.These securities promise to make one future payment.When they are issued, their lives are less than one year.

Fixed-income securities are longer-term debt obligations of corporations or governments.These securities promise to make fixed payments according to a pre-set schedule.When they are issued, their lives exceed one year.#4Treasury BillsDirect obligations of US governmentSell at discount & mature at parIncome exempt from state & local tax91, 182 & 365 day maturityIssued weekly / monthly via competitive bidMinimum $10,000 denomination#Treasury Bill YieldsYields on money market instruments are not always directly comparable. Bank discount yieldRate quoted in WSJBased on 360 day yearUses par amount as divisor Bond equivalent yieldUses 365 day yearIgnores compounding Effective annual yieldConsiders compounding#Figure 2.2 Treasury Bill Yields

#Bank Discount Yield (Discount) Mat DaysBidAskedChgYldApr 05, 07 904.914.90-0.015.03

#Annualized Bank Discount Rate:

rbd = bank discount rateP = market price of the billn = number of days to maturity

To Get Price:1. Deannualize yield using 360 day year2. Subtract from par3. Convert to $#Bank Discount Yield Example1. Deannualize using 360 day year4.90 x 90/360 = 1.225 (discount)

2. Subtract from par100 - 1.225 = 98.775(% of par)

3. Convert to $.98775 x $10,000 = $9,877.50or:P=(100- (yield * n/360)) 10000

#Bond Equivalent Yield (BEY)

10.2.2015However, the cost of borrowing is actually the yield on the bill.#Effective Annual Yield Assumes reinvestment every n days; 365/n

#Other Money Market Securities:Certificates of Deposit (CD) Issued byDenominationMaturityLiquidityDefault riskInterest typeTaxation Depository InstitutionsAny, $100,000 or more are marketableVaries, typically 14 day minimum3 months or less are liquid if marketableUp to $250,000 is insuredAdd onInterest income is fully taxable#14Commercial PaperCommercial PaperIssued by

MaturityDenominationLiquidityDefault riskInterest typeTaxation Large creditworthy corporations and financial institutionsMaximum 270 days, usually 1 to 2 monthsMinimum $100,0003 months or less are liquid if marketableUnsecured, Rated, Mostly high qualityDiscountInterest income is fully taxableNew Innovation: Asset backed commercial paper is backedby a loan or security. They were used to raise funds to invest in other assets (eg subprime mortgages). #15Bankers Acceptances & EurodollarsBankers AcceptancesOriginates when a purchaser of goods authorizes its bank to pay the seller for the goods at a date in the future (time draft). When the purchasers bank accepts the draft it becomes a contingent liability of the bank and becomes a marketable security.Sell at discount from par; NegotiableEurodollarsDollar denominated (time) deposits held outside the U.S. Hence they escape US regulation.Pay a higher interest rate than U.S. deposits.#16Federal Funds and LIBORFederal FundsDepository institutions must maintain deposits with the Federal Reserve Bank. Federal funds represents trading (lending/borrowing) of excess reserves held on deposit at the Federal Reserve.Key interest rate for the economy

LIBOR (London Interbank Offer Rate)Rate at which large banks in London (and elsewhere) lend to each other. Base rate for many loans and derivatives.#17Repurchase Agreements and ReversesRepurchase Agreements (RPs or repos) Short term sales of securities arranged with an agreement to repurchase the securities at a higher price.It is basically overnight borrowing for the dealer.For the investor, a RP is lending money and obtaining security title as collateral.

A Reverse Repo is the mirror image of a repo.#18Money Market InstrumentsCall Money RateInvestors who buy stock on margin borrow money from their brokers to purchase stock. The borrowing rate is the call money rate.The loan may be called in by the broker.#19Bond Markets - Fixed-Income SecuritiesExamples: U.S. Treasury notes, corporate bonds, car loans, student loans.

Potential gains/losses:Fixed coupon payments and final payment at maturity, except when the borrower defaults. Possibility of gain (loss) from fall (rise) in interest ratesDepending on the debt issue, illiquidity can be a problem. (Illiquidity means it is possible that you cannot sell these securities quickly.)#20Figure 2.4 Listing of Treasury Issues

#Listing of Treasury IssuesRateMo/YrBidAskChgAskYld4.000Feb 14n96:0996:10+104.61

Coupon: 4% per yearMaturity: Feb 2014n: note; i: inflation indexedTick: 1/32 = 0.03125

Dealers quoation:Buy price: 96:09 = 96.9/32 = 96.28125% >> $9628.125Sell price: 96:10 = 96.10/32 = 96.3125% >> $9631.25#Turkish Gov Papers, as of 7/4/2011Simple rate = [(100-96.066)/96.066]*(365/188)=0.0795Simple rate = [0.04095]*(365/188)=0.0795Compounded = [(100/96.066)^(365/188)]-1=0.0810

Simple rate =[(100-89.464)/89.464]*(365/489)=0.0878Compounded =[(100/89.464)^(365/489)]-1=0.0866DescriptionSecurityPriceDays to MaturityMaturity DateYield(%)Compound Yield(%)TRT121011T19Tahvil96,066188,0012/10/20117,958,10DescriptionSecurityPriceDays to MaturityMaturity DateYield(%)Compound Yield(%)TRT080812T26Tahvil89,464489,0008/08/20128,788,66#Fixed Income Capital MarketFederal agency debtGovt backed: GNMA (Government National Mortgage Association) Govt sponsored: FNMA (Federal National Mortgage Association) FHLMC (Federal Home Loan Mortgage Corporation) FHLB (Federal Home Loan Bank) In September 2008, Federal government took over FNMA and FHLMC. #Mortgage Backed Securities(Pass-through Securities)Mortgage Backed Security is an interest in a tranche of pooled home mortgagesEach pool of home mortgages is allocated to homogenized tranches (with respect to risk, liquidity, etc) Lender collects Principal and interest (P&I) from homeowners; get a service cut and passes them to agenciesAgencies make the payments to CMO owners based on seniority of tranches that CMO belongs to. #

#Figure 1.4 Cash Flows in a Mortgage Pass-Through Security

#2710/4/2011Investments and Portfolio MgmtCapital Market - Fixed Income InstrumentsMortgage-Backed SecuritiesPolitical encouragement to spur affordable housing led to increase in subprime lending

Private banks began to purchase and sell pools of subprime mortgages

Pool issuers assumed housing prices would continue to rise, but they began to fall as far back as 2006 with disastrous results for the markets.#28Conforming mortgages met traditional creditworthiness standards. Until about 2006, Fannie and Freddie only underwrote or guaranteed conforming mortgages. Under political pressure to make housing available to low income families, Fannie and Freddie began securitizing and backing subprime mortgages (mortgages to households with insufficient income to qualify for a standard mortgage) and so called Alt-A mortgages which lie between conforming and subprime. CMOs, Cont.Risks: Rising & Falling Interest Rates

Rising interest rates Increases mortgage payments and increases defaults and cause smaller collection of P&Is. Senior debt served first, lower tranches may get nothing.Falling interest rates- Prepayment of mortgages by house owners. That means decrease in returns for CMOs again.

#Municipal BondsIssued by state & local GovtGeneral obligation - full faith & creditRevenue bond - project oriented (airport, hospital, road, port, etc.)Industrial revenue - used to finance a commercial enterprise by private firmTax status: exempt from federal (state) tax#Taxable Equivalent YieldLet:Rm = municipal bond yield R = normal taxable yield T = tax rateTo be indifferent between municipal bonds and treasury bonds, after-tax yields have to be equal: Rm = R (1 - t)So the taxable equivalent yield is: R = Rm / (1 - t)#Taxable Equivalent YieldExamplesSuppose Rm = 5% and t = 31%. What is equivalent R? R = 5% / (1 - .31) = 7.246%

Suppose you are in 28% tax bracket. Which of the following should you buy? Rm = 5.5%, R = 7.9% R after tax = 7.9% (1 0.28) = 5.688%#Capital Market - EquityCommon stockResidual claimCash flows to common stock?In the event of bankruptcy, what will stockholders receive?

Limited liabilityWhat is the maximum loss on a stock purchase?#33Residual Claim- Lowest priority in case of bankruptcy. First Debtholders, then preferred, then common. Limited Liability- Can only lose your initial investmentPreferred- Have a fixed dividend stream that generally must be paid before common stock dividendsTax-Important to know that when one company owns stock in another, the dividends have a partial tax exemption.Common StockExamples: IBM shares, Microsoft shares, Intel shares, Google shares, etc.

Potential gains/losses:Many companies pay cash dividends to their shareholders. However, neither the timing nor the amount of any dividend is guaranteed.The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.#34Common Stock Price Quotes Onlineat http://finance.yahoo.com First, enter symbol.

Resulting Screen

#35Capital Market - EquityPreferred stockFixed dividends: limited gains, non-voting

Priority over common

Tax treatmentPreferred & common dividends are not tax deductible to the issuing firmCorporate tax exclusion on 70% dividends earned#36Residual Claim- Lowest priority in case of bankruptcy. First Debtholders, then preferred, then common. Limited Liability- Can only lose your initial investment(Exclusion is for holdings of domestic preferred only)Preferred- Have a fixed dividend stream that generally must be paid before common stock dividendsTax-Important to know that when one company owns stock in another, the dividends have a partial tax exemption.Preferred StockExample: Citigroup preferred stock (Do a Google search for it).

Potential gains/losses:Dividends are promised. However, there is no legal requirement that the dividends be paid, as long as no common dividends are distributed.The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.#37Capital Market - EquityDepository ReceiptsAmerican Depository Receipts (ADRs) also called American Depository Shares (ADSs) are certificates traded in the U.S. that represent ownership in a foreign security.#38UsesTrack average returnsComparing performance of managersBase of derivatives

Factors in constructing or using an index Representative? Broad or narrow? How is it constructed?Stock and Bond Indexes#39Can anyone name some well know indexes. S&P, Dow,etc?Can use as a benchmark or as a passive portfolio. Often used as the base asset for derivatives.Is it based on the market value or price?Construction of IndexesHow are stocks weighted?How much money do you put in each stock in the index?

Price weighted (DJIA)

Market-value weighted (S&P500, NASDAQ)

Equally weighted (Value Line Index)#40Price Weighted- Add up the prices of the stock and divide by a given divisor. Higher priced shares get more weight. (Bad, High price doesnt always mean it is big)Market-Value- Based on the market cap of the firm.Equally weighted-Each companys returns are weighted equally.Constructing market indices Weighting schemes : Price weighted average assumes buy 1 share each stock Value weighted: considers not only price but also # shares o/s:$ invested in each stock are proportional to market value of each stock

Equal weighted: considers not only price but also # shares:invest same amount of $ in each stock regardless of market value of stock #VW and EW are often considered True Indexes because they measure value today with value at a prior point in time. a) price weighted series Time 0 index value is Time 1 index value = 210/3 = 70Performance = (70/66.67) 1 = 0.0499 = 5%

Problems:similar % change movements in higher price stocks cause proportionately larger changes in the index

splits arbitrarily reduce weights of stocks that split in index

(10+50+140)/3 = 200/3 = 66.67#42Dow divisor in 2005 was 0.130DJIA startedin 1896, that's why still used. Been around so long, part of tradition.

a) price weighted series Time 0 index value is Time 1 index value = 185/3 = 61.67Problem?Refigure denominator (10+25+140) / Denom = 66.67Denominator = 2.62486875Time 1 index value = (20+25+140) / 2.62486875 = 70.47

(10+50+140)/3 = 200/3 = 66.67#43Dow divisor in 2005 was 0.130DJIA startedin 1896, that's why still used. Been around so long, part of tradition.

b) Value weighted series

c) Equal weighted series: Assume invest $300 in each

d) Why do the two differ?

#4450% change in price of A and about 7% change in price of CExamples of IndexesDow Jones Industrial Average (30 Stocks)

Standard & Poors 500 CompositeNASDAQ Composite (> 3000 firms)NYSE CompositeWilshire 5000 (> 6000 stocks)#45Dow is based on a price-weighted average. Narrow group.S&P 500- Much more broad market-value weighted index. Often used as the benchmark for the market.NASDAQ Composite-Very broad index of firms using the over-the-counter Nasdaq system.NYSE composite-Market value weighted of all NYSE stocksWilshire 5000- largest index approx. 7000 stocksDerivativesPrimary asset: Security originally sold by a business or government to raise money.

Derivative asset: A financial asset that is derived from an existing traded asset, rather than issued by a business or government to raise capital. More generally, any financial asset that is not a primary asset.

#46DerivativesFutures contract: An agreement made today regarding the terms of a trade that will take place later.

Option contract: An agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specified price for a set period of time.

#47DerivativesFutures contract: An agreement made today regarding the terms of a trade that will take place later. Ex: Financial futures (i.e., S&P 500, T-bonds, foreign currencies, and others); Commodity futures (i.e., wheat, crude oil, cattle, and others).

In a futures contract the purchaser of the contract (the long) agrees to purchase the specified quantity of the underlying commodity at contract expiration at the price (futures price) set in the contract.

The contract seller (the short) agrees to deliver the underlying commodity at contract expiration in exchange for receiving the agreed upon price.

#48Contract Specifications: C, CBOTContract Spec: C,CBOT TradingUnit: 5,000 bushelsTickSize: 1/4 c/bushel ($12.50/contract)QuotedUnits: US $ per bushelInitialMargin: $2,025Maint Margin: $1,500ContractMonths: Mar, May, Jul, Sep, DecFirstNoticeDay: Last business day of month preceding contract month.LastTradingDay: The business day prior to the 15th calendar day of the contract month.TradingHours: 9:30 a.m. - 1:15 p.m. Chicago time, Mon-Fri.Trading in expiring contracts closes at noon on the last trading day.DailyPrice Limit: 20 cents/bu ($1,000/contract), none for spot month#Corn (CBOT) Futures Price Quotes Contract Size: 5000 BushelsOpenHighLowLastTimeSetChgVolMar'14452456448 6/8455 6/8 14:07Feb 25455 6/84 2/8141751May'14458461 6/8454 2/8461 2/8 14:07Feb 25461 2/83 4/8155283Jul'14459465 6/8459465 2/8 14:07Feb 25465 2/8346337Sep'14-465462465 13:27Feb 25465310211Dec'14462 4/8468 4/8462 4/8467 6/8 14:07Feb 25467 6/82 6/825319#50Option ContractsA call option gives the owner the right, but not the obligation, to buy something, while a put option gives the owner the right, but not the obligation, to sell something.

The something can be an asset, a commodity, or an index also called underlying asset.

The price you pay today to buy an option is called the option premium.

The specified price at which the underlying asset can be bought or sold is called the strike price, or exercise price.#51Option ContractsAn American option can be exercised anytime up to and including the expiration date, while a European option can be exercised only on the expiration date.

Options differ from futures in two main ways:Holders of call options have no obligation to buy the underlying asset.Holders of put options have no obligation to sell the underlying asset.To avoid this obligation, buyers of calls and puts must pay a price today. Holders of futures contracts do not pay for the contract today. #52Option Position: Long Call Profit from buying one European call option: option price = $3, strike price = $100, option life = 2 months533020100-5708090100110120130Profit ($)Terminalstock price ($)#Option ContractsPotential gains and losses from call options: Buyers:Profit when the market price minus the strike price is greater than the option premium. Best case, theoretically unlimited profits.Worst case, the call buyer loses the entire premium.

Sellers:Profit when the market price minus the strike price is less than the option premium.Best case, the call seller collects the entire premium.Worst case, theoretically unlimited losses.

Note that, for buyers, losses are limited, but gains are not.#54Option Position: Long Put Profit from buying a European put option: option price = $5, strike price = $100553020100-5100908070110120130Profit ($)Terminalstock price ($)#Option ContractsPotential gains and losses from put options: Buyers:Profit when the strike price minus the market price is greater than the option premium. Best case, market price (for the underlying) is zero. Worst case, the put buyer loses the entire premium.

Sellers:Profit when the strike price minus the market price is less than the option premium.Best case, the put seller collects the entire premium.Worst case, market price (for the underlying) is zero.

Note that, for buyers and sellers, gains and losses are limited.#56Investing in Stocks versus Options, I.Investing in Stocks:Suppose you have $20,000 for investments. Macron Technology is selling at $50 per share.

Number of shares bought = $20,000 / $50 = 400

If Macron is selling for $55 per share 3 months later, gain = ($55 400) - $20,000 = $2,000 (RoR: %10)

If Macron is selling for $45 per share 3 months later, gain = ($45 400) - $20,000 = -$2,000 (RoR: -%10)#57Investing in Stocks versus Options,II.Investing in Options:A call option with a $50 strike price and 3 months to maturity is also available at a premium of $4.

A call contract costs $4 100 = $400, so number of contracts bought = $20,000 / $400 = 50 (for 50 100 = 5000 shares, worth of $250,000)

If Macron is selling for $55 per share 3 months later, gain = {($55 $50) 5000} - $20,000 = $5,000 (RoR: %25)

If Macron is selling for $45 per share 3 months later, gain = ($0 5000) $20,000 = -$20,000 (RoR: -%100)#58StockPrice0Quantity0P1Q1

A$ 1040$ 2040

B50805080

C1405014050

StockPrice0Quantity0P1Q1

A$ 1040$ 2040

B508025160

C1405014050

StockPriceBQuantityBP1Q1

A$ 1040$ 1540

B508025160

C1405015050